2 ETF investments for cautious investors

Should you invest in ETFs?

By Jean Chatzky

Exchange-traded funds, or ETFs, are portfolio chameleons. They have characteristics that make them well suited to long-term passive investing, just like mutual funds. ETFs also lend themselves to short-term tactical strategies because of their structure.

That can be dicey for small investors. Most investors do best when they refrain from trading frequently, and many of the exotic and esoteric strategies employed by ETFs may be far beyond the needs of individual investors. But small investors can take advantage of the investments' flexibility and innovation in a couple different ways.

Two types of ETF investments actually help reduce volatility in a portfolio, so they may be employed by investors who want to control against the vagaries of, say, rising interest rates or currency fluctuations.

What it is: Target maturity bond ETF

Target or fixed maturity bond ETFs are like the offspring of an individual bond and an ETF: You get a passel of bonds in one investment that all mature in the same year.

Guggenheim was the first company to offer target maturity corporate bond ETFs, and now BlackRock's iShares offers them as well. Guggenheim offers high-yield and corporate bond ETFs dated 2014 through 2020 and 2014 through 2022, respectively.

They're very useful for "targeting specific points in the yield curve in particular," says CFP professional Peter Lazaroff, CFA, portfolio manager at Acropolis Investment Management in St. Louis.

Why they're smart investments

Fixed maturity bond ETFs blend the best of both individual bonds and actively managed bond funds, according to Drummond Osborn, president of Osborn Wealth Management in LaPorte, Indiana.

They offer the diversification benefits of a bond mutual fund with the lower interest rate risk associated with an individual bond -- provided you hold it to maturity.

Investors get "diversification, greater certainty of yield to maturity and a date to mark on the calendar for the return of proceeds. Because the individual bonds which comprise the ETF all mature within the same calendar year, an investor has a greater sense of the amount of principle being returned," Osborn says.

In contrast, bond mutual funds have no set maturity and constantly buy and sell issues -- whether to replace maturing bonds or to meet investor redemptions or as part of the strategy. The shifting holdings make it more difficult for investors to understand what they own. Because all the bonds in a mutual fund won't be held until maturity, investors could lose principal if interest rates rise.

Caveats

Though fixed maturity ETFs are less expensive than many bond mutual funds, they do have some costs and expenses.

"Obviously, the ETFs have internal expense ratios and a transactional brokerage cost for their purchase," says Osborn.

The expense ratios are pretty reasonable compared with those of mutual funds. The average expense ratio for Guggenheim's BulletShares short-term, intermediate-term and corporate bond ETFs is 0.24 percent, according to Morningstar. The average expense ratio for the BulletShares high-yield bond ETFs is 0.42 percent.

Fixed maturity bond ETFs typically trade at a premium, so investors should be aware that they could overpay for the investments. Osborn recommends using limit orders to try to get a price closer to the net asset value of the fund. A limit order will also help investors avoid the caprices of the market hidden in the spread between the bid and ask.

"You can look on the Morningstar website and see where it has traded and where it is now. I can be a little patient and pick it up at a slightly lower price," Osborn says.

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